Loan forgiveness? Great, but beware the tax.
Loan forgiveness is helping indebted Americans. But the amount of the loan forgiveness can be taxed by the IRS.
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Bob Scharin, senior tax analyst for Thomson Reuters in New York, said consumers need to pay attention to rules, such as the residence exception, to understand whether they would owe extra taxes when they receive a 1099-C.Skip to next paragraph
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Other tax-saving exceptions for canceled debt apply to those who have gone through bankruptcy or are insolvent.
Most taxpayers will need professional tax help to understand whether they qualify for exemptions relating to forgiven or canceled debt.
"We have had customers who received these forms for either debt cancellation on credit cards or on their mortgage," said Matthew Sheldon, who owns a Liberty Tax Service outlet in Sterling Heights, Mich.
"In most cases, if the debt was secured by the house, it is forgiven if you have moved out of that house and given it back to the bank to resell," he said.
But again, specific rules apply.
One Detroit-area homeowner who went through a foreclosure noted that he didn't owe extra taxes based on the 1099-C he received regarding the foreclosure. Even so, he's upset because he has received calls from bill collectors even though the debt was supposedly forgiven.
"It's like paying double," he said. Or it would be if a consumer owes extra taxes as a result of forgiven debt and then still hears from bill collectors.
Many people don't understand the concept of cancellation of debt as income to report on taxes in the first place. Who would imagine that getting $15,000 of credit card debt forgiven could generate $15,000 of reportable income that would be subject to tax?
"In essence, having a debt discharged puts the individual in a better financial position, so it is income – akin to the creditor paying the debtor money and then taking it back to pay off the debt," Scharin said.
In the past, forgiven debt or canceled debt would have applied more frequently to a small business or company. As a result, the rules aren't easy to read.
Now, though, more individuals are dealing with canceled debt because of the Great Recession.
"The information that's out there may not be targeted for the individual who is going through it now," Scharin said.
In some cases, people do not realize that a debt was canceled or that they're looking at a tax headache.
Some students have had student loan debt canceled because of a disability but are surprised that they may owe taxes on a forgiven amount. Under current law, the canceled debt is treated as taxable income, yielding a tax bill, said Mark Kantrowitz, publisher of Fastweb.com.
Kantrowitz said he gets questions on this all the time and it's mainly an issue for disability discharge.
The forgiveness of the remaining student loan balance after 25 years in an income-based repayment program is taxable, too, he said.
Yet Scharin noted that if the former student is insolvent, some or all of the debt discharged may not be taxable. Under some special programs, some other types of forgiven student loan debt wouldn't be taxable, either.
Kantrowitz said that if student loan debt is canceled as part of a forgiveness program for working in a particular field, such as health care in an underserved community, the debt that is forgiven is tax-free.
The same is true for public service loan forgiveness programs, he said.
If you receive a 1099-C for any canceled debt, though, you cannot ignore it. The IRS gets a copy of that 1099-C, too. Even in cases where you don't owe extra taxes, you'd need to file Form 982 to let the IRS know why the debt discharge reported on the Form 1099-C is not taxable to you.
And in many cases, some debt may be far more unforgiving than you imagine.
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